Bye-bye Fed funds rate

posted at 4:07 pm on February 12, 2010 by King Banaian

Any number of people seem to want Fed Chair Ben Bernanke to tell us when he will exit from the extraordinary monetary policy of the last two years. Yesterday in written testimony to Congress (he will appear when Congress gets over Snowmaggedon), Bernanke outlined a strategy, but didn’t give a date for when he would execute it.

“Although at present the U.S. economy continues to require the support of highly accommodative monetary policies, at some point the Federal Reserve will need to tighten financial conditions by raising short-term interest rates and reducing the quantity of bank reserves outstanding,” he wrote.

“We have spent considerable effort in developing the tools we will need to remove policy accommodation, and we are fully confident that at the appropriate time we will be able to do so effectively.”

Mr. Bernanke, however, did provide new details of a major concern: how, as the recovery proceeds, to gradually shrink the balance sheet, which along with a vast array of assets also includes $1.1 trillion that banks are holding with the Fed.

Mr. Bernanke suggested that a new policy tool — the interest rate on excess reserves, which the Fed began paying in October 2008 — would be a vital part of the Fed’s strategy.

Increasing that interest rate, he said, will have the effect of pushing up other short-term interest rates, including the benchmark fed funds rate — the rate at which banks lend to each other overnight.

The text is here. In it Bernanke also suggests a new instrument for removing excess reserves from the system, a term deposit banks could make to the Fed that would compete with Treasuries as a store of liquidity for them.

The Federal Reserve would likely auction large blocks of such deposits, thus converting a portion of depository institutions’ reserve balances into deposits that could not be used to meet their very short-term liquidity needs and could not be counted as reserves. A proposal describing a term deposit facility was recently published in the Federal Register, and we are currently analyzing the public comments that have been received. … we expect to be able to conduct test transactions this spring and to have the facility available if necessary shortly thereafter. Reverse repos and the deposit facility would together allow the Federal Reserve to drain hundreds of billions of dollars of reserves from the banking system quite quickly, should it choose to do so.

Both new instruments provide a means by which the Fed can increase its balance sheet without impacting the money supply, by inducing banks not to use their excess reserves for deposit expansion. I was familiar with both these instruments in Macedonia, where excess reserves were close to 30% of the money supply. The problem there was that it created flabby banks unwilling to lend, since easy government revenue was close at hand. The Fed does not directly spend taxpayer dollars, but its remission of excess earnings from its portfolio to the Treasury would be shifted to banks, and that indirectly expands the government’s need for additional debt to cover its spending. That’s not likely to go over well.

The biggest signal was not a date but a statement that the Federal funds rate would no longer be a policy instrument for the Fed, at least for awhile:

As a result of the very large volume of reserves in the banking system, the level of activity and liquidity in the federal funds market has declined considerably, raising the possibility that the federal funds rate could for a time become a less reliable indicator than usual of conditions in short-term money markets. Accordingly, the Federal Reserve is considering the utility, during the transition to a more normal policy configuration, of communicating the stance of policy in terms of another operating target, such as an alternative short-term interest rate. In particular, it is possible that the Federal Reserve could for a time use the interest rate paid on reserves, in combination with targets for reserve quantities, as a guide to its policy stance, while simultaneously monitoring a range of market rates. No decision has been made on this issue; we will be guided in part by the evolution of the federal funds market as policy accommodation is withdrawn. The Federal Reserve anticipates that it will eventually return to an operating framework with much lower reserve balances than at present and with the federal funds rate as the operating target for policy.

The last time the Fed abandoned the Fed funds target was October 1979, when then-Chair Paul Volcker thought it more prudent to stop inflation by using a target on reserves. That lasted perhaps three years, maybe less (see Alton Gilbert for more.) That period led to rather high volatility in interest rates may have contributed to the double-dip recessions in 1980-82.

It would be fair criticism of the above to say we really haven’t used the Fed funds target for awhile and that this is just recognition of reality. But the FOMC statement still focused on it, and the Fed had not enunciated until yesterday what we might look at for an alternative target. Now we have. This will make reading the next FOMC statement on March 16 very interesting indeed.

UPDATE: John Taylor doesn’t like the term deposits from the Fed to the banks.

In my view, Fed borrowing instruments should be avoided as much as possible because they delay essential adjustments in reserves and create precedents which make it easier to deviate from the monetary framework in the future. Similarly, the instrument of paying interest on reserves to achieve the short term interest rate target should be used only during a well defined transition period.

He argues instead for a rule that ties Fed fund rate increases to a decrease in reserves. It would make Fed policy more predictable.

[P]olicy makers could treat this exit rule as an exit guideline rather than a mechanical formula to be followed literally, much as a policy rule for the interest rate is treated as a guideline rather than mechanical formula. They would vote on how much to reduce reserves at each meeting along with the interest rate vote. Note that the exit rule would we working in tandem with a policy rule for the interest rate, such as the Taylor rule.

With all that’s going on in Europe, this might be sliding under the radar. It shouldn’t.

This post was promoted from GreenRoom to HotAir.com.
To see the comments on the original post, look here.

“… at some point the Federal Reserve will need to tighten financial conditions by raising short-term interest rates and reducing the quantity of bank reserves outstanding,” he wrote.

i.e. kiss monetary stability good-bye and wave to your housing value as it slides down a cliff with the rising long term rates that are going to be kicked off by this.

In related news, Bernanke just announced that the Fed is going to use the new perpetual motion machine (secretly built by liberal idiots) to make sure that none of the consequences of horrendous monetary policy end up effecting anyone. We can print money free, now. Yippee!!

What this means is that the funded liquidity rate of the variable interest denominators will essentially lead to wholesale marginalization of predictive asset returns. The indicative response would be to fundamentally reduce the additive responsibilities of your fiscal appropriations to better take advantage of consumptive shortfalls and market bias as it pertains to joint trust and formulated exigencies.

The last time the Fed abandoned the Fed funds target was October 1979, when then-Chair Paul Volcker thought it more prudent to stop inflation by using a target on reserves. That lasted perhaps three years

I’m old enough to remember, interest rates and inflation were like Willie Wonka’s elevator…they went through the roof….

WOW JUST WOW Thats a whole lot of words to say that since people are saving the bankers don’t like all the interest they are paying out! The system is rigged and we know it!! On a side note WE NEED TO COLLECT ALL THE MONEY FROM THE DEADBEAT DEFAULT ARTISTS IN FANNY AND FREDDIE!!

1)The Fed has been printing money like a drunken sailor in order to purchase government debt and mortgage backed securities
2) This props up the housing market and makes it easier for the Treasury to fund the deficit
3) This money printing has not led to increased bank lending because the Fed is paying banks to keep the excess cash (reserves) in the Fed’s own account (0.25% risk-free interest)
4) Inflation will become a threat when banks’ risk appetite returns and they start lending the excess cash
5) The Fed does not want to sell its mortgage-backed securities or government debt for the reasons outlined in 2)
6) Because of this, the only way to prevent inflation will be to hike the interest rate on reserves
7) Interest on reserves has thus become the dominant tool of monetary policy

Basically it is a carbon copy of the 1970’s except worse! We have too much money on the street now like a vacuum they have to suck it all back in. This in turn will create a hyper inflation none of which we have seen before no matter how pretty Bernake wants to make it.

That is why they’re looking to play with people IRA, MM’s and 401K’s and steal from you to buy their treasury debt in annuities to make it all better for them but you’re screwed!

Ludwig von Mises: THERE IS NO MEANS OF AVOIDING THE FINAL COLLAPSE OF A BOOM BROUGHT ABOUT BY CREDIT EXPANSION. THE ALTERNATIVE IS ONLY WHETHER THE CRISIS SHOULD COME SOONER AS THE RESULT OF A VOLUNTARY ABANDONMENT OF FURTHER CREDIT EXPANSION OR LATER AS A FINAL AND TOTAL CATASTROPHE OF THE CURRENCY SYSTEM INVOLVED.

Forgot to add that interest on reserves is a pretty useless tool for containing inflation in the long run. Rather than withdrawing the newly created money (this happens when the Fed sells a bond/security), it merely immobilises the new cash for a period. Moreoever, the paying of interest adds even more money to the monetary base. Bernanke would just be kicking the inflationary bomb a little further into the future.

The federal government is by far the largest borrower in the world. The Federal reserve had been manipulating the interest rates by changing the overnight rate, thus impacting all longer interest rates. The Federal reserve failed to raise interest rates to ‘normal’ levels for more than 8 years, culminating in finally hitting the bottom at 0.25%!

Now, the Federal Reserve is unable to raise the overnight interest rate without destroying the federal governments balance sheet. Sooner or later, this is going to happen due to the absurd spending by the Democrats and Obama. The Federal government should be reducing the deficit now and not increasing it.

Bernanke is scratching around looking for a way to get the banks to raise interest rates on private loans without forcing the Federal government to also pay higher interest rates. This will ultimately FAIL!

At some point, interest rates will rise, and the treasury will be forced to pay higher interest rates. Considering ONLY the current debt ceiling of ~14 trillion and an income(tax revenue) of ~2.2 trillion, all it takes is an interest rate of ~15% to consume all of the revenue. Of course, we will have a failed dollar long before this point. Anyone that remembers interest rates of the late 70’s and early 80’s knows this is not only possible, but in fact is probable.

The bottom line is that this government has spent more than they take in. Our debt is all over the world and they are not getting the warm and fuzzy feeling we can pay them back. This bho, team, and the dc bunch keep putting us more and more in debt. WHO will stop them? This ‘grand guy’ was given the ok by dc. Interest rates will go up, taxes will go up, unemployment will go up, more and more people will be employed by the feds, the banks will get more money, the gm’s will get more money, the unions will get their slimy fingers all over our nation with their demands and funds to
keep them in the life they think they should get.
If there are those of us still working, boy are we in for it
L

ObaMao isn’t a “liberal”— he’s a neo-Com Marxist. The most Marxist move ObaMao has made (thus far) was his summary execution of three (un-Mirandized) Somali teens at sea— manifestly more extreme than the post-9/11 moistening of KSM that Leftists howl over, ad nauseum. ObaMao’s mass murder of American free enterprise runs a close second.

ObaMao’s budget is an example of the Cloward-Pivin model of planned economic destruction of a functioning capitalist economy via sabotage. Outlays are so gigantic, and so dreadfully misspent, that our financial infrastructure will soon collapse. A trillion dollar tax increase and spending rising by $10 trillion dollars over the next decade is probable. If so, government default will occur, only offset by mass currency printing, which will then bankrupt the general populace. The middle class will fall. Chronic inflation will result, causing America to lose its sterling credit rating. Global financial players must dump the dollar as it swan-dives. Then, hyperinflation will accelerate, and the era of superpower America will end.

I don’t understand this. It sounds very important but… someone who can explain on my limited econ level…

petunia on February 12, 2010 at 7:23 PM

The gov’s credit cards are maxed out, they keep opening new lines of credit to 1)keep spending & 2)pay the interest on the previous credit-due. The bubble created by doing this has reached a point that if the interest rate is increased then it will consume the whole paycheck. (their thinking is that deficit spending will stimulate the economy. read up on Keynes vs Von Mises) I thinks that’s reductive enough. Someone else take a stab at it?

I don’t understand this. It sounds very important but… someone who can explain on my limited econ level…

petunia on February 12, 2010 at 7:23 PM

There are some choice nuggets above. It’s quite simple, and I commented a little before in the green room before it got promoted. It goes like this…

The problem for Ben is his jawboning about liquidity removal is just that, jawboning. He will get ow3nd by the bond vigilantes coming up real soon with the MBS purchasing exhausted and he can no longer control rates through QE purchasing.

Simple short is that Bernanke is losing control, and has to resort to tools to deal with what he has done (and ironically what he’s almost forced to continue). Simple short on Ben Bernanke, if his lips are moving he’s lying.

As it relates to you and J6P, there’s a contraction of Dollars on the street. This is a DEFLATION. As much as they want to dinker with rates (Reserve or otherwise), the market will ultimately set the rates on Treasury debt.

Cash is a fairly good strategy right now because all of the defaults (Greece, PIIGS, US States – think Cali, CDS, Derivatives) almost always settle in USD! That means they need to get Dollars from someone, that means a DEMAND for USD, which makes it MORE scarce.

At some point, US Treasury debt isn’t even a “safe” bet and that is when you start seeing rates rise. That is the apex of where you want to bail out of USD into commodities, which could mean gold, food, lead (Read: Inflation). You will have to keep your eye on it because it can happen slowly or overnight if a sovereign blows up (like Dubai did in Nov 2009, but was “contained”… So much for that – they’re CDS hit the high today reached during that Nov period).

One theory of the fed’s monetary policy is based upon the assumption that the average US working bubba produces X dollars of goods and services in a year. If there are Y bubbas, there needs to somewhere near x * y dollars in the economy for everything to work out. New money is issued via investment vehicles of one sort or another flowing from the Fed.

A proper rate of interest on this new money in a relatively free flowing justly operated economy might probably be 4 to 5%. However, government regulations has constipated the free flow of investments, with a lot of ‘money’ waiting upon approval of this or that approved politically oriented behavior before being put to good use. To clear up this log jam, the Fed has lower rates to the point that they are basically giving away money in hopes the ‘free money’ will compensate for all the wishful left wing regulations and social engineering that is going on.

Fiscally responsible small business folks (who will never be eligible for a bailout) are justifiably skeptical of this entire process and will continue to sit it out until this top heavy cart of regulatory/economic crapola is tossed out. Many (if not most) small businesses operate at the edge of solvency and are fully aware of the risks of picking up ‘free’ money of any sort that has strings attached… They know they are more likely than not to end up getting hung by those strings as not.

ObaMao isn’t a “liberal”— he’s a neo-Com Marxist. The most Marxist move ObaMao has made (thus far) was his summary execution of three (un-Mirandized) Somali teens at sea— manifestly more extreme than the post-9/11 moistening of KSM that Leftists howl over, ad nauseum.

Bottom line, about how long will this “5-ish” mortgage rate still be around? I want to re-fi my mortgage within the next few weeks.

Also, I am in a cash only position (missed the market turn down as well as the market semi-recovery), mainly because I have been so busy with a start up company that I haven’t had time to study what/where I want/need to invest.